Chesapeake Suffering From Gas Pains

Jim Brown
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Chesapeake Energy (CHK) has gas! They have a lot of gas and they are trying to get rid of the pain produced by the excess.

Chesapeake announced yesterday they were selling 390 billion cubic feet of gas to Barclays PLC for $1.15 billion. The gas will come from the Barnett shale. Compared to the amount of gas CHK expects to produce from the field in 2011 this is a drop in the bucket. CHK is expecting to produce 280 million cubic feet per day from the Barnett in 2011.

This is the eighth deal Chesapeake has done with Barclays and also the cheapest price per MCF. With the futures at 52-week lows at $3.60 the sale to Barclays was priced at $2.95 per MCF. That is a 20% discount to the future price.

Barclays has purchased a total of $4.7 billion in future production totaling about one trillion cubic feet. Barclays will resell the gas in 2011 as it is produced. If gas prices continue lower they will lose money. Barclays is betting that drillers will have to curtail production in order to keep gas prices above the cost of finding and production. If drillers and producers limit production the price of gas will rise and Barclays could make a very nice profit.

The problem is most drillers are over committed. They bought every acre they could find, brought in extra rigs, trained crews and created thousands of miles of infrastructure complete with processing facilities. They assumed if they built the network the money would come.

Unfortunately for companies like Chesapeake they over spent and ran out of cash flow. The price of gas continues to decline but their expenses continue to rise. The faster they produce the less they and others like them, get less for their gas. Chesapeake has tried to curtail production to push prices higher but unless other producers also curtail the effort will fail. There are too many producers and they are not united.

Chesapeake found a buyer with deep pockets. CHK is giving up future profits in order to pay bills today. Ostensibly CHK is doing the deals to pay down debt and improve their credit rating back t investment grade. You and I both know what will happen when (if) that happens. When their rating goes up they will borrow billions more to fund their growth and their credit will decline again.

The only way this story will have a happy ending is when U.S. demand returns and gas consumption pushes prices higher. That may take a long time because there are more than a thousand uncompleted gas wells where producers are waiting for prices to rise before spending the money to complete them. If gas suddenly moved back over $5 the rush to complete wells would cause a surge of gas into the system in the months that followed.

Utility companies are rushing to build cheap natural gas fired electric plants but it could be a couple years before any material quantity are completed. Coal is still cheaper than gas on an acquisition basis and now that the cap and tax plan is dead there is a new surge in coal plants as well.

Gas companies are suffering from an embarrassment of riches. They have a prime product that American needs but this is a pure case of too much of a good thing. At least the electric consumer is going to profit from the glut in the form of lower utility bills.

Let's hope the gas producers don't run out of buyer like Barclays or we could see a series of unfortunate events in the finances of these producers.

Jim Brown

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